Chapter 8 - Supply under perfect competition

Question 1

1. Economists categorize an industry by three criteria, use these to describe a perfectly competitive industry. What is the key economic implication of these three assumptions concerning perfect competition?

Answer 1

A perfectly competitive industry has no barriers to entry and features many firms selling identical products (consumer view the output of the different producers as perfect substitutes and do not care who made it). The key economic implication is that the firm do not have a choice about which price to charge and can sell as much output as it wants at the market price (hence, it will never choose to charge a price below the market price).

Question 2

Name the three criteria economists use to describet market structures

Answer 2

The number of firms in the industry, the type of product sold (does the consumer care which company produced it?), and barriers to entry.

Question 3

2. Why does a perfectly competitive firm face a horizontal demand curve?

Answer 3

Perfectly competitive firms are price takers. As a result, the demand curve facing a perfectly competitive firm is horizontal; no matter what quantity the firm produces, the market price at which the firm sells its product stays constant. It must sell its output at whatever price is determined by supply and demand forces in the market as a whole. They can sell as much output as they want at the market price. The demand curve facing a firm in a perfectly competitive market is perfectly elastic at the market equilibrium price.

Question 4

4. What is the relationship between the market price and marginal cost when a perfectly competitive firm is maximizing its profit?

Answer 4

At its profit-maximizing output, the perfectly competitive firm’s marginal cost equals the market price.

Question 5

Now that we know the marginal cost and marginal revenue, how does our firm maximize profit in a perfectly competitive market?

Answer 5

Because perfectly competitive firms take the market price as given, we only need to focus on the choice of output. We know that total cost is always going to rise when output increases, that is, marginal cost is always positive. Similarly, we know that the firm’s marginal revenue here is constant at all quantities and equal to the good’s market price. The key impact of changing output on the firm’s profit depends on which of these marginal values is larger. If the market price (marginal revenue) is greater than the marginal cost of making another unit of output, then the firm can increase its profit by making and selling another unit, because revenues will go up more than costs. If the market price is less than the marginal cost, the firm should not make the extra unit.
The quantity at which the marginal revenue (price) from selling one more unit of output just equals the marginal cost of making another unit of output is the point at which a firm maximizes its profit. This point occurs at Q*.

Question 6

5. A firm operating at a loss will decide whether to shut down based on the relationship between the market price and the firm’s average variable cost. When will a firm choose to operate? Why does a firm ignore its fixed cost when making this decision?

Answer 6

A firm will stay in operation so long as the market price is at least as large as the firm’s average variable cost at its profit-maximizing level. In the short run, fixed costs need to be paid whether the firm stays in operation or not; because of this, the firm’s fixed costs will not enter into its operating decisions.

Operate if P ≥ AVC*
Shut down if P < AVC*
Or (the same)
Operate if TR ≥ VC
Shut down if TR < VC

Question 7

6. What is a perfectly competitive firm’s short-run supply curve?

Answer 7

The portion of the short-run marginal cost curve above the minimum average variable cost is the perfectly competitive firm’s supply curve. At any price below the minimum average variable price (here they would have greater profits or less losses by shutting down), the firm shuts down, and supply goes to zero. Because of this relationship between marginal cost and the firm’s short-run supply curve, anything that changes marginal cost will shift supply.

Question 8

7. How do we use firms’ short-run supply curves to create the industry short-run supply curve?

Answer 8

The short-run industry supply is the horizontal sum of the short-run supply curve of all individual firms in the industry (at any given price, we find the individual firms’ outputs, add them up, and plot their sum to get the industry quantity supplied). This industry supply curve represents the combined decisions of all firms in the industry. The industry supply curve determines the price in a perfectly competitive market. An industry supply curve, then, indicates how much total output an industry supplies at any particular price.

Question 9

8. What happens to short-run industry supply when firms’ fixed costs change?

Answer 9

In the short run, fixed costs do not affect firms’ operating decisions, and any changes in fixed costs do not affect the short-run industry supply.

Question 10

Why does industry output increase as price increases?

Answer 10

Industry output increases as price increases for two reasons. One is that individual firms’ supply curves are often upward-sloping-an individual firm will tend to produce more as the market price rises. The other comes from the fact that some firms might have higher costs than others, so they only begin operating at higher price levels.

Question 11

9. Define producer surplus. What is the relationship between profit, producer surplus, and fixed costs?

Answer 11

Producer surplus is the aggregation of price-marginal cost mark ups across every unit of output that the firm makes, or the revenue a firm makes above and beyond its variable cost. A firm’s profit is its producer surplus minus its fixed cost.

Question 12

What is the producer surplus for a competitive firm and why is it different from profit?

Answer 12

If we add up the firm’s marginal cost for all the units of output it produces, we have its variable cost. And if we add up the firm ‘s revenue for every unit of output it produces, we have its total revenue. That means the firm ‘s total revenue minus its variable cost equals the sum of the price-marginal cost mark-ups it earns on every unit it sells-that is, its producer surplus:
PS = TR - VC
Producer surplus does not include fixed costs, profit does. A new firm may operate with profit less than zero but it will never operate with producer surplus less than zero because that means each unit costs more to produce than it sells for, even without fixed costs.

Question 13

What is the producer surplus for a competitive industry?

Answer 13

Producer surplus for an entire industry is the same idea as producer surplus for a firm. It is the area below the market price but above the short-run supply curve-now, however, it is the industry supply curve rather than the firm’s.

Question 14

In the short run, a firm supplies output at the point where its short-run marginal cost equals the market price. This price can be below the firm’s average total cost, but it must be at least as high as its short-run average variable cost. In other words, the firm must earn producer surplus, or else it shuts down. The short-run supply curve is therefore the portion of a firm’s short-run marginal cost curve that is above its short-run average variable cost curve and zero otherwise. Where does the firm produce in the long-run?

Answer 14

In the long run, however, a firm produces where its long-run marginal cost equals the market price. Moreover, because all inputs and costs are variable in the long run, the firm’s long-run supply curve is the part of its long-run marginal cost curve above its long-run average total cost curve (LATC = LAVC because there are no fixed costs in the long run).

Question 15

10. Perfectly competitive industries have free entry and exit in the long run. When will firms decide to enter an industry? When will a firm exit an industry? (and how do we define free entry and exit?)

Answer 15

Free entry - the ability of a firm to enter an industry without encountering legal or technical barriers
Free exit - the ability of a firm to exit an industry without encountering legal or technical barriers.
Firms enter a perfectly competitive industry when the market price is above minimum long-run average total cost, or when firms in the industry earn positive economic profits. Conversely, a firm exits the industry when the market price is below minimum long-run average total cost, or when the firm earns negative economic profits. (This exit shifts the supply curve in, raising the market price. Exit continues until the market price rises to minimum average total cost). Hence, free entry and exit are forces that push the market price in a perfectly competitive industry toward long-run minimum average total cost.

Question 16

11. When do economists say that a market is in a long run competitive equilibrium?

Answer 16

Long-run competitive equilibrium occurs when price is equal to the firm’s minimum average total cost. In other words, in the long run, there is no entry or exit into the industry, and firms earn zero economic profits.

Question 17

The bottom line is that if there is free entry, the price in a perfectly competitive industry will be driven down toward the minimum average total cost of the industry’s firms, and no firms will be making a profit. This important idea seems odd. How could the firms make no profit? And, if they make no profit, why bother?

Answer 17

The answer is that the world of perfect competition is tough. You may have a good idea, but the profit you make only lasts until everyone else enters and copies it. One thing to remember about this no-profit condition is that it refers to economic profit, not accounting profit. The opportunity cost of the business owners’ time is included in the firms’ costs. It means business owners make only enough to stay in business-that is, to be no worse off than their outside option-and no more.

Question 18

What are two important characteristics of the long-run equilibrium in a perfectly competitive market?

Answer 18

First, even though the industry’s short-run supply curve slopes upward, the industry’s long-run supply curve is horizontal at the long-run minimum average cost. Remember that a supply curve indicates the quantity supplied at every price. Long-run competitive equilibrium implies that firms produce where price is equal to minimum average total cost.

Question 19

What happens to the equilibria in the short- and in the long run, if there is an increase in demand?

Answer 19

In the short run, when entry is limited, the initial response is an increase in both equilibrium output and the market price as the industry moves up its short-run supply curve. The producers earn a positive economic profit and producer surplus. The market price, which was originally at the minimum long-run average total cost and therefore only just high enough for firms to earn zero economic profit, is now above this level. Because price is above average cost, profit is positive and so new firms will enter the market. Industry output increases at every price, and the industry’s short-run supply curve shifts out. With the demand curve now stable, the supply shift raises industry output and lowers the market price, and consumers move along their demand curve. Entry continues until the price falls back to the minimum average cost level.

Question 20

What happens to the equilibria in the short- and in the long run, if there is a decrease in demand?

Answer 20

Demand falls, price and quantity fall along the initial supply curve. Producers make negative profits, some leave the industry, supply decreases, Q falls, and prices rebound. When demand falls, exit from the industry is the force that brings price back (up) to the minimum long-run average total cost level.

Question 21

What happens to the equilibria in the short- and in the long run, if there is a decrease in producer costs?

Answer 21

The cost reduction shifts down both the marginal and average total cost curves of the industry firms. Because of the decrease in marginal cost, every firm will want to supply more output at any given price, and each firm’s short-run supply curve shifts out and as a result the industry short-run supply curve shifts out (both because the lower costs mean existing supplier shave a higher optimal quantity and because the high price attracts new suppliers to enter the market). This outward shift raises the industry’s quantity supplied and lowers the market price. The shift continues until supply reaches the point at which the market price has fallen to the new minimum average total cost level.

Question 22

How can we define long-run supply and long-run supply curves in constant-, increasing-, and decreasing-cost industries?

Answer 22

Constant-cost industry - An industry whose firms’ total costs do not change with total industry output. The supply curve is horizontal at a price equal to the minimum average total cost of its producers.

Increasing-cost industry - An industry whose firms’ total costs increase with increases in industry output. An upward sloping long-run supply curve (not as steep as short-run because they account for entry and exit). Shifts from one long-run equilibrium to another in response to a demand shift are similar to the case above for a constant-cost industry. The only difference is that entry only brings price back down to the new, higher long-run average total cost level.

Decreasing-cost industry - An industry whose firms’ total costs decrease with increases in industry output. The long-run supply curves for these industries are downward-sloping. Again, the short-run transition between long-run equilibria when demand for the industry’s product increases looks like the constant-industry case, but now entry continues past the point where the market price is driven down to the old long-run average cost level. Instead, entry continues until the price falls all the way to the new, lower minimum average total cost.

Question 23

What is economic rent?

Answer 23

Returns to specialized inputs above what firms paid for them. What’s important to recognize is that economic rents are determined by cost differences relative to other firms in the industry. That’s because the profit earned by the scarce input depends on how much lower the firm’s costs are than its competitors’ costs. The larger the cost difference, the larger the rent.

Question 24

12. Economic rents are returns to scarce inputs above what firms paid for them. When will a firm earn economic rents?

Answer 24

A firm earns economic rents when it has lower costs than other firms in its industry. In a perfectly competitive market where firms have different costs, the long-run market price equals the minimum average total cost of the highest-cost firm remaining in the industry. That highest-cost firm makes zero profit and zero producer surplus. The other firms have minimum average total costs that are lower than the minimum average total cost of the highest-cost firm, and therefore lower than the market price. They make a positive profit on every sale, and this profit is larger the lower their costs.

Question 25

13. Perfectly competitive firms earn zero economic profits in the long run. How can a firm earn zero economic profits and still yield positive economic rents?

Answer 25

Economic profits incorporate a firm’s opportunity costs. Once opportunity costs are included, all firms-even those earning positive economic rents-earn zero economic profits in perfect competition. This willingness to pay for the economic rent inherent to the input raises the opportunity cost of the input to the firm that currently owns it-by using the input, they’re giving up the ability to sell it to another firm. Once this opportunity cost is subtracted from the firm’s revenue, its economic profit is no higher than if the input earned no rent at all.

Question 26

Why is a perfectly competitive firm’s total revenue curve a straight line from the origin?

Answer 26

A perfectly competitive firm’s marginal revenue is the market price for the good. Think about what this outcome implies. Total revenue is P x Q. When a firm is a price taker, P does not change no matter what happens to Q. For a price taker, P is a constant, not a function of Q. This fact means that a perfectly competitive firm’s total revenue is proportional to its output. If output increases by 1 unit, total revenue increases by the price of the product. For this reason, a perfectly competitive firm’s total revenue curve is a straight line from the origin.

Question 27

How does the demand curve facing a price taker differ from the market demand curve and why?

Answer 27

The demand curve facing a price taker is completely flat i.e. completely elastic because the firm can sell all it wants at the market price.

Question 28

What is the big difference between the long-run and the short-run supply curve?

Answer 28

In the long run all inputs are flexible and firms can enter and exit freely in response to market conditions.

Question 29

What is the long-run supply curve?

Answer 29

In the long run, firms will not stay in business unless all costs can be covered by revenue, therefore: the long-run supply curve is the portion of the long-run marginal cost curve above the long-run average total cost curve.

Question 30

What is the slope at the profit-maximizing quantity for a firm in a perfectly competitive market?

Answer 30

There, the slope of the total revenue curve (the marginal revenue-here, the market price) equals the slope of the total cost curve (the marginal cost at Q*).